Output and the Exchange Rate in the Short Run Objectives Causes of output, exchange rates, and inflation changes Determination of output and exchange rates in the short run Examine how macroeconomic policy affects output and the current account and how they can be used to maintain full employment Determinants of Aggregate Demand in an Open Economy An economy’s output is the sum of four types of expenditure that generate national income: consumption, investment, government purchases, and the current account A country’s overall short-run output level depends on the aggregate demand for its products In the long run, domestic output depends only on the available domestic supplies of factors of production In the short run factors of production can be over or under employed because of shifts in aggregate demand that have not yet had their full long-run effects on prices Aggregate demand for an open economy’s output is the sum of consumption demand, investment demand, government demand, and net export demand For now we assume government and investment demand are given Determinants of Consumption Demand Consumption is dependent on disposable income (C = Y – t) So we take consumption as a function of disposable income C = C(Yd) Determinants of Current Account The current account is dependent on • The domestic currency’s real exchange rate against foreign currency (that is, the price of a typical foreign expenditure basket in terms of domestic expenditure baskets) • Domestic disposable income A country’s current account balance is a function of its currency’s real exchange rate, q = EP*/P (price of foreign basket in terms of domestic basket), and of domestic disposable income, Yd CA = CA (Ehf x Pf/Ph, Yd) Determinants of Current Account Representative domestic expenditure basket places heavier weight on local goods Consequently a rise in the price of the foreign basket in terms of domestic baskets, will cause a rise in the relative price of foreign output to domestic output How does this affect exports and imports? When q rises, foreign products prices rise, domestic output now purchases fewer units of foreign output Foreign consumers demand more of your exports raising exports and improving current account balance Determinants of Current Account An increase in Yd causes domestic consumers to increase their spending on all goods, including imports worsening the current account To Summarize q = Current Account q = Current Account Yd = Current Account Yd = Current Account The Equation of Aggregate Demand AD = C + I + G + (X-M) AD = C(Y-T) + I + G + CA(EhfPf/Ph, Y-T) Where Yd = Y-T Aggregate demand for home output can be written as a function of the real exchange rate, disposable income, investment demand, and government spending AD = D(EhfPf/Ph, Y-T, I, G) We now want to see how aggregate demand depends on the real exchange rate and domestic GNP given the level of taxes, T, investment demand, I, and government purchases, G The Equation of Aggregate Demand A real depreciation of the home currency raises aggregate demand for home output, other things equal; a real appreciation lowers aggregate demand for home output a rise in domestic real income raises aggregate demand for home output, other things equal, and a fall in domestic real income lowers aggregate demand for home output. Increase in AD is less than increase in output, so the slope is less than 1 How Output is Determined in the Short Run Output market is in equilibrium when real domestic output, equals aggregate demand for domestic the output: Y = D(EhfPf/Ph, Y-T, I, G) We assume money prices of goods and services are temporarily fixed hence short run implication How Output is Determined in the Short Run Y1: demand = output Y2: demand > output Y3: demand < output Output Market Equilibrium in the Short Run Determination of exchange rate and output simultaneously in the short run Asset market and output market equilibrium Output, the Exchange Rate and Output Market Equilibrium Currency depreciation raises AD & output by increasing demand for local goods/services DD Schedule We now derive the DD schedule - shows all combinations of output and the exchange rate for which output market is in short-run equilibrium (aggregate demand = aggregate output). Relates E & Y when P & P* are fixed DD Schedule A change in the following causes a shift in the DD schedule: • government demand/purchases, • taxes, • Investment, • Prices (domestic and foreign), • Domestic consumption behavior; • Foreign demand for home output. Shift in DD Schedule Rise in government purchases = rightward Rise in taxes = leftward Rise in investment= rightward Rice in domestic prices = leftward Rise in foreign prices = rightward Rise in domestic consumption = rightward Rise in home output= rightward Asset Market Equilibrium in the Short Run – AA Schedule To have a complete picture we have to ensure that the exchange rate and output level consistent with output market equilibrium should also be consistent with asset market equilibrium. Exchange rate and output combinations that are consistent with equilibrium in the domestic money market and the foreign exchange market is called the AA schedule Output, the Exchange Rate and Asset Market Equilibrium Remember interest parity condition (foreign exchange market is in equilibrium only when the expected rates of return on domestic and foreign currency deposits are equal) Remember interest rates that enter the interest parity relationship are determined by the equality of real money supply and real money demand in national money markets Now we combine these asset market equilibrium conditions to see how the exchange rate and output must be related when all asset markets simultaneously clear Foreign interest rate is taken as given AA Schedule For a given expected future exchange rate, Ee , the interest parity condition describing foreign exchange market equilibrium Rh = Rf + (Ee – E) / E Domestic interest rate satisfying the interest parity condition must also equate the real domestic money supply to real money demand Ms/P = L(R,Y) Now we can study the changes in the exchange rate that must accompany output changes so that asset markets remain in equilibrium We assume domestic price level, P; foreign interest rate, Rf; and expected future exchange rate, Ee are given AA Schedule A rise in output from Y1 to Y2 raises aggregate real money demand raises the equilibrium domestic interest rate, with Ee and Rf fixed, the domestic currency appreciates to bring forex market back into equilibrium AA Schedule For any output level Y, there is a unique exchange rate E satisfying the interest parity condition (given the real money supply, the foreign interest rate, and the expected future exchange rate) A rise in output causes a rise in the home interest rate and a domestic currency appreciation Shift in AA Schedule A change in the following factors causes a shift in the AA Schedule: • Domestic money supply, Ms; increase in Ms given fixed output = domestic currency depreciation in forex market = AA shifts upward • Domestic price level, P; increase in P given fixed output = reduction in Ms = increase in interest rate = domestic currency appreciation in forex market = AA shifts downwards • Expected future exchange rate, Ee; increase in Ee increases r, shifting r on foreign currency deposits to the right = domestic currency depreciation = AA shifts upwards • Foreign interest rate, R*; increase in R* raises return on foreign deposits (shifts right) = domestic currency depreciation = AA shifts upwards • Aggregate real money demand; reduction in Md = lower interest rate = causes a depreciation = shifts AA upwards DD Schedule & AA Schedule We find the economy’s short-run equilibrium by finding the intersection of the DD and AA schedules The assumption that output is temporarily fixed makes this short run equilibrium Further, we continue to assume foreign interest rate Rf, the foreign price level Pf, and the expected future exchange rate Ee also are fixed DD Schedule & AA Schedule: Short Run Equilibrium At 2, E jumps from 2 to 3 because asset markets adjust quickly. Y rises to meet AD & the economy moves to 1 Temporary Changes in Monetary & Fiscal Policy Monetary policy (changes in money supply) Fiscal policy (changes in government spending) Macroeconomic policies counteract economic disturbances that cause fluctuations in output, employment, and inflation We now want to see how shifts in government macroeconomic policies affect output and the exchange rate. We assume foreign interest rate, Rf, foreign price level, Pf, domestic price level, Ph, are fixed in the short run We assume temporary policy change do not affect the long-run expected exchange rate, Ee (as in the long run) Monetary Policy Increase in Ms pushes down Rh shifting AA upward but does not affect DD (1-2) To preserve interest parity condition exchange rate depreciates making home products cheaper than foreign products AD then increases matched by increase in output Increase in Ms causes depreciation of domestic currency, expansion of output, and therefore increase in employment Fiscal Policy Increased government purchases/decreased taxes raises transaction increasing money demand pushing Rh up Currency appreciates and output increases Policies to Maintain Full Employment Temporary monetary expansion and temporary fiscal expansion both raise output and employment They can be used to counteract the effects of temporary disturbances that lead to recessions and the vice versa for booms What happens if there’s a shift in consumer tastes away from local products? A decrease in AD for domestic goods causes DD to shift leftward, currency depreciates and output reduces (indications of recession) Temporary fiscal expansion shifts demand back to its original position, restoring full employment and returning to E1 Temporary monetary expansion shifts the asset market equilibrium curve right, restores full employment but cause further depreciation Policies to Maintain Full Employment What happens if there is a temporary increase in demand for money (likely to cause a recession)? Increase in money demand pushes up the domestic interest rate and appreciates the currency, making domestic goods more expensive and causing output to reduce (shifting AA downward) Temporary money supply increase shifts the AA curve back to AA1 and returns the economy to its initial position Temporary fiscal expansion shifts the DD schedule and restores full employment at point 3 but there is a greater appreciation of the currency Problems of Policy Formulation Inflation Bias: Macroeconomic policy can display an inflation bias, leading to high inflation but no average gain in output. Government can raise output when it is abnormally low (-creating a politically useful economic boom). Workers and firms may anticipate this and raise wage demands and prices. The government then has to use expansionary policy to prevent a recession. Disturbance Source: Government concerned about the effect on exchange rate by its policy needs to know the source of the disturbance before it can choose between monetary and fiscal policy. This is in reality not easy. Bureaucracy: Shifts in fiscal policy are often made after lengthy legislative deliberation, while monetary policy is usually exercised quicker by the central bank. Governments are likely to respond to disturbances by changing monetary policy even when fiscal policy would be more appropriate. Problems of Policy Formulation Government Budget Impact: A tax cut or spending increase may lead to a larger government budget deficit, which must sooner or later be closed by a fiscal reversal Time Lags: Policies appear to act swiftly in our model because it is simple. In real life, they operate with lags of varying lengths. Precision of Forecasts: Evaluating the size and persistence of a given shock makes it hard to know exactly how much monetary or fiscal policy to administer. This forces policy makers to base their actions on forecasts and hunches that may turn out to be quite wide of the mark. Permanent Monetary Expansion In the long-run, we assume the economy is at a long-run equilibrium position and the policy changes are the only economic changes that occur (other things equal) Rh = Rf Temporary increase in Ms causes the asset market equilibrium schedule to shift upward Permanent increase in Ms, however, affects the expected future exchange rate, E, leading to a proportional rise in Ee, causing a higher shift in AA (than temporary increase) Output is above its full-employment level and labor and capital are working overtime Permanent Monetary Expansion Price level P is rising to keep up with rising production costs (workers demand higher wages and producers raise prices to cover their increasing production costs). Domestic goods are more expensive relative to foreign goods, discouraging exports and encouraging imports causing DD to shift left Increasing price level reduces money supply causing AA to shift left The economy therefore adjusts at 3 to a permanent increase in money supply Permanent Fiscal Expansion Has impact in the output market and affects the asset markets through its impact on long-run exchange rate expectation Rise in G causes DD to shift right causing long run appreciation of currency pushing AA downwards and output remains unchanged all due to additional expectation of appreciation Appreciation “crowds out” aggregate demand for domestic products by making them more expensive relative to foreign Macroeconomic Policies and the Current Account XX, shows combinations of the exchange rate and output at which the current account balance would equal some desired level, CA(EP*/P, Y - T) = X. Along XX, the current account is constant at the level CA = X Arise in Y encourages spending on imports, worsening the current account unless a currency depreciates Since actual level of CA can differ from X, the economy’s short-run equilibrium doesn’t have to be on the XX curve XX is flatter than DD (along DD, the domestic demand for domestic output rises by less than the rise in output itself (since income is either saved or spent on imports)) To prevent an excess supply of home output E must rise quickly along DD to make export demand rise faster than import demand ie CA must rise sufficiently along DD as output rises to compensate for domestic saving To the right of point 1, DD is above XX curve, CA > X; to the left of point 1, DD lies below XX curve (CA < X) Monetary expansion moves the economy to point 2 and thus raises the current account balance. Temporary fiscal expansion moves the economy (DD) to point 3, while permanent fiscal expansion moves economy (AA) to point 4; in either case, the current account balance falls Gradual Trade Flow Adjustments & Current Account: J Curve Underlying the DD-AA model, we assume a real depreciation of the home currency improves the current account while an appreciation worsens it Reality = more complex J Curve: It is observed that a country’s current account worsens immediately after a real currency depreciation and begins to improve after some months later (most import and export orders are placed months in advance reflecting buying decisions that were made on the old real exchange rate). Point 3 is reached within a year of the real depreciation in most industrial countries, and the current account continues to improve afterward Gradual Trade Flow Adjustments & Current Account: Exchange Rate Pass through and Inflation To understand how nominal exchange rate movements affect the current account in the short run, we examine closely the linkage between nominal exchange rate and prices of exports and imports The percentage by which import prices rise when the home currency depreciates by 1% is known as the degree of pass-through from the exchange rate to import prices If you buy a car from South African manufacturer at the price of R1.5m (at the exchange rate of K0.96/R) that costs K1,440,000 but if the kwacha depreciates to K1.01/R in a year then the car will cost K1,515,000, a difference of K75,000 to the Zambian importer. If the Zambian importer pays the whole K75,000 then that’s a 100% or complete pass through (or the degree of pass through is 1) Exchange Rate Pass through and Inflation In the version of the DD-AA model above, the degree of pass-through is 1; any exchange rate change is passed through completely to import prices. With P also fixed in the short run in our model, this implies a passthrough of 1 to the foreign prices of exports. However, exchange rate pass-through can be incomplete In our previous example, importer might decide to absorb 40% of the price increase (K30,000) and the importer pays 60% (K45,000) meaning importer pays K1,485,000. (The degree of pass through is 0.6) Incomplete pass-through has complicated effects, on the timing of current account adjustment because of slow adjustment of trade volumes to slow adjustment of relative prices Gradual Trade Flow Adjustments & Current Account: Current account, wealth and exchange rate dynamics A permanent fiscal expansion would cause both an appreciation of the currency and a current account deficit, transferring wealth to foreigners. Domestic consumption is falling over time and foreign consumption is rising. Foreigners have a relative preference for consuming the goods that they produce, and as a result, the relative world demand for home goods will fall and the home currency will tend to depreciate in real terms. Initially, the home currency will appreciate as the current account balance falls sharply. But then, over time, the currency will depreciate The Liquidity Trap Once an economy’s nominal interest rate falls to zero, it becomes difficult for the central bank to reduce it further by increasing money supply. Policy makers are trapped. They may be unable to steer the economy through conventional monetary expansion. Why? At 0% interest, people find money preferable to bonds, therefore bonds would be in excess supply. To clearly see the dilemma a central bank faces when the economy is in a liquidity trap, we consider the interest parity condition when domestic interest rate Rh = 0, Rh = 0 = Rf + (Ee - E)/E If the expected future exchange rate, Ee , is fixed, the central bank raises the domestic money supply so as to depreciate the currency temporarily (raise E today but return it to Ee later) The Liquidity Trap IRP shows that E can’t rise once R = 0. Interest rate would have to become negative. Despite increase in the money supply, exchange rate remains steady at E = Ee /(1 - Rf). Currency cannot depreciate any more At R = 0, people are indifferent about trades between bonds and money. People will accept the additional money in exchange for their bonds with no change in the interest rate from zero and, therefore, no change in the exchange rate An increase in the money supply will have no effect on the economy A central bank that sells bonds will eventually push interest rate up (but this doesn’t help when the economy is in a slump and a fall in interest rates is what is needed) The Liquidity Trap At point 1, output is trapped below full employment level. Exchange rate expectations Ee are fixed The flat segment of AA shows the currency cannot depreciate beyond the level Ee /(1 - Rf) Monetary expansion prolongs horizontal stretch of AA
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